Johnson Ltd
Johnson Ltd., a Canadian company that applies IFRSs, leased equipment from Lessor Inc. on
January 1, 2010, for a period of three years. Lease payments of $200,000 are due to Lessor Inc. each year.
Other expenses (e.g., insurance, taxes, & maintenance) are also to be paid by Lessee Ltd. and amount to
$4,000 per year. The lease contains no purchase or renewal options and the equipment reverts back to
Lessor Inc. on the expiration of the lease. The useful life of the equipment is four years. The fair value of
the equipment at lease inception is $550,000. Lessee Ltd. has guaranteed $40,000 as the residual value at
the end of the lease term. The salvage value of the equipment is expected to be $10,000 after the end of its
economic life.
The lessee’s incremental borrowing rate is 12 percent (Lessor’s implicit rate is 11 percent and is
calculable by the lessee from the lease agreement). The junior accountant of Lessee Ltd. analyzed the assets
under lease and prepared a computation. The senior accountant of Lessee Ltd. reviewed the analysis and
the computation and prepared a separate analysis. As the finance controller, you were given both of the
computations to determine the correct accounting treatment. Calculations and journal entries performed by
your junior and senior accountant are shown below.
Computations by the junior accountant:
Since the equipment reverts back to Lessor Inc., it is an operating lease.
Entries to be posted in Years 1, 2, and 3:
Dr. Rent expense
$200,000
Dr. Other expense
$4,000
Cr. Cash
$204,000
(Operating lease rental paid to Lessor Inc.)
Computations by the senior accountant:
Step 1 — Lease classification
The lease term is for three years. The useful life of the equipment is four years. Since the lease term is
for a major part of the useful life of the equipment, it is a finance lease.
Step 2 — Computation of the lease asset and obligation:
Since the lessee’s incremental borrowing rate is greater than the lessor’s implicit rate in the lease,
compute the present value of the minimum lease payments using the 12 percent rate.
Present value of the minimum lease payments = $200,000 × 2.40183= $480,366
Step 3 — Allocation of payments between interest and lease obligation
Since interest has to be charged on the straight-line method, the following is the allocation of the interest
and the reduction in the lease liability. Year Cash Payment Interest Expense (12%) Reduction in Lease
Obligation Balance of Lease Obligation
Year
0
1
2
3
Cash payment
$
Interest
Expense (12%)
$
Reduction in
Lease Obligation
$
200,000
200,000
200,000
57,643
57,643
57,643
142,357
142,357
142,357
Year 1 Journal Entries:
To record the leased asset/obligation:
Dr. Finance lease asset
Cr.
Finance lease obligation
$480,366
$480,366
To record the cash payment:
Dr. Other expense
Dr. Finance expense
Dr. Lease obligation
Cr. Cash
$4,000
$57,643
$142,357
$204,000
To record depreciation:
Dr. Depreciation
Cr.
Accumulated depreciation
$117,592
$117,592
Depreciable amount = $470,366 = ($480,366 - $10,000 (salvage value))
Annual depreciation charge = $117,592 = ($470,366 / 4 years)
Required
1. Was the junior accountant’s analysis correct? Why or why not?
2. Was the senior accountant’s analysis correct? Why or why not?
3. How would the answer differ under U.S. GAAP?
References: ASC 840 and IAS 17
Balance of
Lease Obligation
$
480,366
338,009
195,652
53,295